How small businesses can master financial planning

South African small businesses face a number of challenges, especially during the first few years of operation.

Arguably, the most significant challenge involves efficient cashflow management, which can be a make-or-break factor. Managing cashflow effectively, however, is only an indicator of a much broader objective, which is proper financial planning.

If structured and informed correctly, a financial plan can serve as a roadmap for success for an entrepreneur.

It’s impossible to predict which obstacles lie ahead as a small business owner – the sudden onset of the pandemic and the civil unrest of 2021, are just two examples of the kind of curveballs that can really shake the foundations of a small business.

But, putting a robust financial plan in place can make entrepreneurs as prepared as possible for what lies ahead.

While there are no hard and fast rules as to how to compile an effective financial plan, there are several key factors that should be considered, regardless of the size or nature of the business.

Your business’s financial standing

Start by assessing your business’s current financial standing. In order to do so, entrepreneurs should have a full understanding of how to analyse financial ratios and how these ratios can serve as an evaluative tool.

In essence, this analysis involves assessing the quantitative relationships between key financial figures from the business's financial statements.

There are four specific categories of ratios that are most commonly referenced as key financial metrics.

1. Profitability ratios

Profitability ratios measure the business's ability to generate profits.

Common profitability ratios include gross profit margin, net profit margin, and return on assets (ROA) or return on equity (ROE). These ratios indicate how effectively the business converts sales into profits and how efficiently it utilises its assets or equity to create profits.

2. Liquidity ratios

Liquidity ratios assess the business’s ability to meet its short-term obligations.

The most commonly used liquidity ratios are the current ratio and the quick ratio. These ratios help determine if the business has enough current assets – assets that are liquid or can be turned into cash quickly - to cover its liabilities, providing a sense of its short-term financial stability.

3. Solvency ratios

Solvency ratios gauge the long-term financial viability of the small business.

Debt-to-equity ratio and interest coverage ratio are examples of solvency ratios. These ratios provide insights into the company's capital structure – how it has raised capital or borrowed money - and its ability to service its long-term debt obligations.

4. Efficiency ratios

Efficiency ratios assess the effectiveness of a small business in managing its assets and liabilities.

For instance, the inventory turnover ratio and accounts receivable turnover ratio show how well the business is managing its inventory and collecting its receivables – or what it is owed- relative to its turnover, respectively.

Forecasting for the future

Another important part of financial management in a small business involves profit planning. This aspect leans on and impacts a broad range of areas including the setting of financial goals (in terms of sales revenue, gross profit, net profit and return on investment), expense management (cost analyses), pricing strategies and risk assessment.

While covering all these aspects may seem like a daunting task, especially for first-time business owners, effective profit planning is very much a work in progress. Profit planning is an ongoing process that requires periodic review and adjustments to adapt to changing market dynamics and business circumstances.

The same can be said of financial planning on the whole, which is a fluid process rather than a static one. The profit margins you expect today, may be very different to the margins you expect to see just a year down the line.

The important part is to set a foundation based on realistic expectations and a practical assessment of what’s possible and what’s not. This will undoubtedly change as the business grows.

A financial plan should also include a component of forecasting, which is the process of predicting future financial performance based on historical data, current trends and anticipated changes in the business environment.

It involves projecting key financial figures, such as sales revenue, expenses, profits, cash flow, and balance sheet items, over a specific period, typically a year or several years ahead.

Financial forecasting plays a vital role in helping small business owners make informed decisions, plan for growth, allocate resources effectively, and identify potential challenges or opportunities.

Master the basics of budgeting

These forecasts and market predictions will provide important insights into how to formulate monthly and yearly budgets, which is a cornerstone of proper financial planning.

Budgets are the mainstay of effective cashflow management and should take into consideration projections on sales and revenue, as well as forecasts on expenses - and include any hidden or seemingly marginal costs that can add up in the end.

Expenses should be looked at in terms of fixed and variable costs, with fixed costs representing expenses that remain constant regardless of the level of production of sales.

In contrast, variable expenses are costs that fluctuate along with the volume of the business’s output or operations.

Following this, it is also important for business owners to evaluate their performance by comparing actual financial results with their budgets. Variances between actual and budgeted figures can highlight areas where the business is excelling or facing challenges, helping to identify areas for improvement.

Many aspects of financial planning require more time and patience than formal expertise or qualifications in areas such as accounting and finance. With the right information and support, business owners can really take control of their financial futures.

It may also be useful to enlist the services of a financial planner, market analyst or adviser to supplement the deep knowledge you have on your business, with an outside and experienced perspective on what may lie ahead. Any resources put into developing a sound financial plan is certainly an investment well-made.